What is a currency tax?
Currency tax represents a financial charge for individual foreign exchange gain, markets trading, or business currency exchanges.
Citizens dealing in foreign currencies should be aware that the Internal Revenue Service (IRS) has imposed a tax on currency exchange at the dollar value. Hence proper records have to be maintained. Citizens also have to pay taxes on their profit from exchanging currencies. The records should specify the exact exchange rate used for converting foreign currency since the IRS may require this information.
Do You Pay Tax on Foreign Exchange Gains?
US citizens can pay tax on foreign exchange gains as foreign earned income, short time capital gain, long time capital gain, or may be exempt from paying taxes.
1. US Foreign Tax Exemption
Foreign exchange tax exemption is valid for all individuals and businesses with a foreign exchange gain of less than $200.
To avoiding wasting resources on paperwork, the IRS has exemption low-value currency exchanges from taxation. Businesses, their employees, and individuals do not have to report direct currency exchanges of value less than two hundred dollars. This allows the individuals to exchange their currency when holidaying abroad, without bothering about taxes when converting the foreign currency back into dollars when they return to the US.
Canada Foreign exchange gains or losses from capital transactions of foreign currencies for Canadian citizens have the same $200 Foreign Tax Exemption.
US foreign exchange tax exemption example:
You are on two weeks vacation in Europe, and you are a US citizen. Before the holiday you exchanged $5000 for Euros. During your holiday exchange rate, EURUSD dramatically changed in your favor, and you have a $100 gain from the exchange rate. You do not pay any tax to the IRS because the gain value is less than $100.
2. Taxes on currency exchange profit
Taxes on currency exchange profit represent taxes on foreign earned income. For all businesses owned by citizens of the United States, including those based in a foreign country, the income earned is taxed at its dollar value on the day it is received. For each journal entry, the exchange rate used should be mentioned. Businesses should use Form 2555 to report the foreign income earned in a year. If the business is not itemizing its deductions in the tax returns, it can form 2555EZ, shorter.
3. Currency markets tax
Traders on currency markets can trade forex, futures, options, and need to pay tax.
There are different types of exchange contracts and different tax options:
- long term capital gains tax
- short term capital gains tax or ordinary income tax
- combination of long term and short term capital gains tax
Long-term capital gains tax represents tax that pays traders who hold assets for more than 1 year. So if you keep EURUSD for one year and make a profit, you need to pay long term capital gains tax.
Short term capital gains or ordinary income tax pay all traders who trade options or forex and hold trades positions for less than 1 year. The majority of traders pay only short term capital gains tax.
Futures traders pay a combination of long term and short time capital gains tax. Futures contracts are split 60/40 between long-term and short-term capital gains rates.
How do day traders pay taxes?
Day traders pay short-term capital gain tax because they hold trade positions for less than 1 year. The short-time capital gain tax has the same rate as ordinary income tax.
To summarize, most exchange contracts are for the short term and taxed at the standard rate for capital gains. The taxation rate depends largely on the duration of time for which the individual held the currency. If the currency were kept for more than one year before it was sold, the long term taxation rate would be applicable for the profit. For futures contract gains, they are divided in the ratio 40:60 so that the taxation rates for short term and long term gain can be applied.
4. Tax on currency exchange for business
If a company exchanges the currency it has at a profit, the transaction gains are taxable. The tax rate will depend on the currency form which the company has. If the currency is held only for paying expenses, it will be taxed at the normal income tax rates, even if it holds the currency for many years. If the business is holding a currency for investment reasons, the capital gains tax rates will be applicable. For currencies held for one year or longer, the long term capital gains tax is applicable, while for a shorter duration, the short term capital gains tax will apply. Other investments like stocks, bonds held in foreign currencies are also taxed like dollar assets.
Business currency exchange example:
A foreign exchange gain or loss accounting example is when the EUR customer pays the invoice to the US seller. Let seller from the US posts an invoice for 100 EUR to a German customer. Let on the invoice date, 100 000 EUR is worth 125 000 USD, and on the payment date value of 100 000 EUR rise from $125 000 to $130 000. In this case, there will be a realized forex exchange accounting gain of $5000.